Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994 to 2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income.
This is a preview of subscription content, access via your institution.
Buy single article
Instant access to the full article PDF.
Tax calculation will be finalised during checkout.
The subsidiary may also be required to prepare financial statements in accordance with local GAAP for a variety of reasons. Our point here is that when the earnings are consolidated and reported for the entire company, all the earnings are reported using U.S. GAAP and are subject to U.S. securities laws.
December 7, 2009, speech before the American Institute of Certified Public Accountants (AICPA) National Conference on Current SEC and PCAOB Developments, Washington, DC (Goelzer 2009).
There are other important papers that are somewhat related to our research but less directly. For example, Duru and Reeb (2002) report evidence that analysts have lower forecast accuracy when firms have greater international diversification. Looking across firms—thus, more similar in spirit to Leuz et al. (2003), Pincus et al. (2007) document the occurrence of the accrual anomaly in foreign countries, and DeFond et al. (2007) provide evidence that earnings announcements are more informative in countries with strong investor protections. In addition, there are other papers beyond Erickson et al. (2004) that study the relation between taxes and earnings management. For example, Badertscher et al. (2009) (discussed below), Frank et al. (2009), and Rego (2003). Frank et al. (2009) find a positive relation between aggressive tax reporting and aggressive financial reporting, and Rego (2003) finds economies of scale in tax planning, such that multinational firms are better able to avoid tax. We do not study tax planning in our paper.
In an analysis of fraudulent financial reporting over the period 1998–2007, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) states: “The SEC named the CEO and/or CFO for some level of involvement in 89 % of the fraud cases, up from 83 % of cases in 1987–1997. Within 2 years of the completion of the SEC’s investigation, about 20 % of CEOs/CFOs had been indicted and over 60 % of those indicted were convicted” (Beasley et al. 2010). Thus, many cases of financial manipulation name central managers as the guilty party. However, some cases are done by “rogue” managers, as the two SEC AAER cases in Sect. 2 indicate. Top management at Boston Scientific and Bristow did not appear to be, and were not accused of being, involved in the fraud.
Many tax havens have a corporate tax rate of zero, but conceptually for this paper we only need havens to impose lower taxes on income than does the U.S.
Our premise assumes that the earnings from the subsidiary are not repatriated and the U.S. tax is not incurred. The Badertscher et al. (2009) study assumes all the income is taxable in the U.S. and that managers lessen the tax via nonconforming earnings management.
Similarly, companies can tax plan for a variety of other reasons, for example, to maximize foreign tax credits. While firms in our sample may be doing such tax planning, to our knowledge such tax planning will not affect our tests. We have constructed the tests using pre-tax measures to avoid incorrect inferences due to tax planning.
Studies examining the absolute value of discretionary accruals include Dechow and Dichev (2002), Frankel et al. (2002), Klein (2002), Chung and Kallapur (2003), Myers et al. (2003), Leuz et al. (2003), and Bergstresser and Philippon (2006). As discussed later, we control for operating volatility in our analyses, following the recommendations of Hribar and Nichols (2007).
See http://info.worldbank.org/governance/wgi/pdf/rl.pdf for a detailed discussion and listing of factors.
See http://www.oecd.org/document/23/0,3343,en_2649_33745_30575447_1_1_1_1,00.html for further details.
This definition captures noncorporate entities, which may not all meet the technical definition of an SPE. We follow prior convention for labeling purposes but recognize that there is measurement error in this variable.
The financials and utilities industries are dropped because we eliminate regulated industries from the sample. Of the 14 firms in Compustat in the tobacco industry, none fulfill all of our sample criteria. Thus, we include a breakdown of 27 (not 30) industries in Table 2.
The mean is not zero because the model is estimated over the larger 69,819 firm-year sample, which is prior to imposing other data requirements to arrive at the final sample.
We use robust regression to control for outliers. In the regressions, all continuous variables are mean centered at zero for ease of interpretation of the interaction effects (Aiken and West 1991). We multiply the dependent variable by 100 to facilitate interpretation of the coefficients as percentages. The standard errors in all regressions are computed after clustering observations by firm and year to mitigate the effects of cross-sectional and intra-firm correlation in the residuals (Petersen 2009). For all regressions we present one-tailed p values for t statistics where we have a prediction and two-tailed p values otherwise.
The breakdown of pre-tax income into pre-tax domestic income and pre-tax foreign income is required by the SEC to be included in the tax footnote of firm’s financial statements to correspond with the breakdown of tax expense into domestic and foreign components.
We use the superscript j to indicate a vector of controls that includes all of the controls in the vector k and also includes RULE OF LAW and HAVEN INTENSITY.
Calculated as −18.633 × 0.487 = −9.1. Note that 0.487 is the standard deviation of RULE OF LAW from Table 3.
We thank an anonymous referee for this suggestion.
A corrupt country was defined to be any country in the most corrupt quartile of the World Bank’s Corruption Index.
The additional control variables include change in receivables, change in inventory, change in cash sales, change in return-on-assets, change in the number of employees, the level of “soft” assets, an indicator for whether the firm issued debt or equity in the period, an indicator for whether the firm has outstanding leases, a measure of ex ante financing needs, Altman’s Z, and industry fixed effects. See Dechow et al. (2011) for detailed definitions of these variables.
Not every treatment firm will match with a control firm, and the propensity score approach involves a trade-off. If the matching process is relaxed so that more firms match, then the resulting matches will be less precise. Conversely, if the matching is required to be very precise, then there will be fewer successful matches.
Aiken, L., & West, S. (1991). Multiple regression: Testing and interpreting interactions. Thousand Oaks, CA: Sage.
Armstrong, C., Jagolinzer, A., & Larcker, D. (2010). Chief executive officer equity incentives and accounting irregularities. Journal of Accounting Research, 48, 225–271.
Badertscher, B., Phillips, J., Pincus, M., & Rego, S. (2009). Earnings management strategies and the trade-off between tax benefits and detection risk: To conform or not to conform? The Accounting Review, 84, 63–97.
Ball, R., & Shivakumar, L. (2006). The role of accruals in asymmetrically timely gain and loss recognition. Journal of Accounting Research, 44, 207–242.
Beasley, M. S., Dana, H. H., & Terry, L. N. (2010). Fraudulent financial reporting: An analysis of U.S. public companies, 1998–2007. Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Berger, P., & Hann, R. (2003). The impact of SFAS No. 131 on information and monitoring. Journal of Accounting Research, 41, 163–197.
Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management. Journal of Financial Economics, 80, 511–529.
Beuselinck, C., Deloof, M., & Vanstraelen, A. (2010). Earnings management contagion in multinational corporations. Tilburg University and Antwerp University working paper.
Bodnar, G., & Weintrop, J. (1997). The valuation of the foreign income of US multinational firms: A growth opportunities perspective. Journal of Accounting and Economics, 24, 69–97.
Bowen, R., Noreen, E., & Lacey, J. M. (1981). Determinants of the corporate decision to capitalize interest. Journal of Accounting and Economics, 3, 151–179.
Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24, 99–126.
Chung, H., & Kallapur, S. (2003). Client importance, nonaudit services, and abnormal accruals. The Accounting Review, 78, 931–955.
Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: the role of accrual estimation errors. The Accounting Review, 77, 35–59.
Dechow, P., Ge, W., Larson, C., & Sloan, R. (2011). Predicting material accounting restatements. Contemporary Accounting Research, 28, 17–82.
Dechow, P., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of their proxies, their determinants and their consequences. Journal of Accounting and Economics, 50, 344–401.
Dechow, P., & Skinner, D. J. (2000). Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons, 14, 235–250.
Dechow, P., Sloan, R., & Sweeney, A. (1995). Detecting earnings management. The Accounting Review, 70, 193–225.
DeFond, M., Hung, M., & Trezevant, R. (2007). Investor protection and the information content of annual earnings announcements: International evidence. Journal of Accounting and Economics, 43, 37–67.
DeFond, M., & Jiambalvo, J. (1994). Debt covenant violation and manipulation of accruals. Journal of Accounting Research, 17, 145–176.
Desai, M., & Dharmapala, D. (2006). Corporate tax avoidance and high-powered incentives. Journal of Financial Economics, 79, 145–179.
Desai, M., Dyck, A., & Zingales, L. (2007). Theft and taxes. Journal of Financial Economics, 84, 591–623.
Dichev, I., & Skinner, D. J. (2002). Large-sample evidence on the debt covenant hypothesis. Journal of Accounting Research, 40, 1091–1123.
Doyle, J., Ge, W., & McVay, S. (2007). Accruals quality and internal control over financial reporting. The Accounting Review, 82, 1141–1170.
Durnev, A., Li, T., & Magnan, M. (2011). Tax avoidance, institutional environment, and financial reporting: evidence from offshore companies. McGill University, University of Windsor, and Concordia University working paper.
Duru, A., & Reeb, D. (2002). International diversification and analysts’ forecast accuracy and bias. The Accounting Review, 77, 415–433.
Dyreng, S., & Lindsey, B. (2009). Using financial accounting data to examine the effect of foreign operations located in tax havens and other countries on U.S. multinational firms’ tax rates. Journal of Accounting Research, 47, 1283–1316.
Dyreng, S., Mayew, W., & Willams, C. (2010). Religious social norms and corporate financial reporting. Duke University and University of Michigan working paper.
Erickson, M., Hanlon, M., & Maydew, E. (2004). How much will firms pay for earnings that do not exist? Evidence of taxes paid on allegedly fraudulent earnings. The Accounting Review, 79, 387–408.
Fan, N. (2008). A study of foreign earnings management using an empirical distribution approach. Unpublished dissertation, University of Texas at Arlington.
Fields, T., Lys, T., & Vincent, L. (2001). Empirical research on accounting choice. Journal of Accounting and Economics, 31, 255–307.
Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2005). The market pricing of accruals quality. Journal of Accounting and Economics, 39, 295–327.
Frank, M., Lynch, L., & Rego, S. (2009). Tax reporting aggressiveness and its relation to aggressive financial reporting. The Accounting Review, 84, 467–496.
Frankel, R., Johnson, M., & Nelson, K. (2002). The relation between auditors’ fees for nonaudit services and earnings management. The Accounting Review, 77, 71–105.
Goelzer, D. (2009). Seven years of the public company accounting oversight board: What has been accomplished and what remains to be done? Speech before the AICPA conference, Washington, DC, December 7, 2009.
Golden, T., Skalak, S., & Clayton, M. (2006). A guide to forensic accounting. New York: Wiley.
Gompers, P., Ishii, J., & Metrick, A. (2003). Corporate governance and equity prices. Quarterly Journal of Economics, 118, 107–155.
Grullon, G., Kanatas, G., & Weston, J. (2010). Religion and corporate (mis)behavior. Rice University working paper.
Hagerman, R., & Zmijewski, M. (1979). Some economic determinants of accounting policy choice. Journal of Accounting and Economics, 1, 141–161.
Healy, P. (1985). The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics, 7, 85–107.
Healy, P., & Wahlen, J. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13, 365–383.
Hennes, K., Leone, A., & Miller, B. (2008). The importance of distinguishing errors from irregularities in restatement research: The case of restatements and CEO/CFO turnover. The Accounting Review, 83, 1487–1520.
Holthausen, R. W. (1981). Evidence on the effect of bond covenants and management compensation contracts on the choice of accounting techniques: The case of the depreciation switch-back. Journal of Accounting and Economics, 3, 73–109.
Hope, O.-K., Kang, T., Thomas, W., & Vasvari, F. (2008). Pricing and mispricing effects of SFAS No. 131. Journal of Business, Finance and Accounting, 35, 281–306.
Hribar, P., & Nichols, D. (2007). The use of unsigned earnings quality measures in tests of earnings management. Journal of Accounting Research, 45, 1017–1053.
Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29, 193–228.
Kedia, S., & Rajgopal, S. (2011). Do the SEC’s enforcement preferences affect corporate misconduct? Journal of Accounting and Economics, 51, 259–273.
Klein, A. (2002). Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics, 33, 375–400.
Kothari, S., Leone, A., & Wasley, C. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39, 163–197.
Leuz, C., Nanda, D., & Wysocki, P. (2003). Earnings management and investor protection: An international comparison. Journal of Financial Economics, 69, 505–527.
McGuire, S., Omer, T., & Sharp, N. (2012). The impact of religion on financial reporting irregularities. The Accounting Review, 87, 645–673.
Miedema, D. (March 4, 2008). FACTBOX—tax havens of the world. Reuters.
Mishkin, F. (1983). A rational expectations approach to macroeconometrics: Testing policy effectiveness and efficient markets models. Chicago, IL: University of Chicago Press for the National Bureau of Economic Research.
Myers, J., Myers, L., & Omer, T. (2003). Exploring the term of the auditor–client relationship and the quality of earnings: A case for mandatory auditor rotation? The Accounting Review, 78, 779–799.
Petersen, M. (2009). Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies, 22, 435–480.
Pincus, M., Rajgopal, S., & Venkatachalam, M. (2007). The accrual anomaly: International evidence. The Accounting Review, 82, 169–203.
Rego, S. (2003). Tax-avoidance activities of U.S. multinational companies. Contemporary Accounting Research, 20, 805–833.
Schipper, K. (1989). Commentary: Earnings management. Accounting Horizons, 3, 91–102.
Securities and Exchange Commission, Division of Enforcement. (2011). Enforcement manual. Office of Chief Counsel, Washington, DC, August 2.
Srinivasan, S., Wahid, A., & Yu, G. (2011). Admitting mistakes: An analysis of restatements by foreign firms listed in the U.S. Working paper, Harvard Business School.
Sweeney, A. (1994). Debt-covenant violations and managers’ accounting responses. Journal of Accounting and Economics, 17, 281–308.
Thomas, W. (1999). A test of the market’s mispricing of domestic and foreign earnings. Journal of Accounting and Economics, 28, 243–268.
Watts, R., & Zimmerman, J. (1978). Towards a positive theory of the determination of accounting standards. The Accounting Review, 53, 112–134.
We appreciate helpful comments from Patricia Dechow (editor), Annalisa Prencipe (discussant), two anonymous referees, Dirk Black, Alex Edwards, Jürgen Ernstberger, Jeff Hoopes, Chad Larson, Alina Lerman, K. Ramesh, Tjomme Rusticus, Terry Shevlin, Nemit Shroff, Shyam Sunder, Jake Thomas, Jake Thornock, Alex Young, Frank Zhang, and workshop participants at the 2011 European Accounting Association Annual Congress, the 2011 London Business School Accounting Symposium, the 2011 Review of Accounting Studies Conference, Florida State University, University of Chicago, University of Notre Dame, University of Southern California, University of Toronto, Texas A&M University, and the Yale 2010 Accounting Research Conference. Maydew acknowledges financial support from the Arthur Andersen Faculty Fund.
About this article
Cite this article
Dyreng, S.D., Hanlon, M. & Maydew, E.L. Where do firms manage earnings?. Rev Account Stud 17, 649–687 (2012). https://doi.org/10.1007/s11142-012-9194-7
- Earnings management
- Rule of law
- Tax havens
- Multinational firms